The Economics of Money, Banking, and

Financial Markets

Chapter 4
The Meaning of Interest Rates

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 Learning Objectives

1. Calculate the present value of future cash flows and the

yield to maturity on the four types of credit market
instruments.
2. Recognize the distinctions among yield to maturity, current
yield, rate of return, and rate of capital gain.
3. Interpret the distinction between real and nominal interest
rates.

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Measuring Interest Rates
• Present value: a dollar paid to you one year from now is
less valuable than a dollar paid to you today.
– Why: a dollar deposited today can earn interest and
become $1×(1+i) one year from today

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Measuring Interest Rates

– To understand the importance of this notion, consider

the value of a $20 million lottery payout today versus a
payment of $1 million per year for each of the next 20
years. Are these two values the same?

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Present Value
Let i = .10
In one year: $100 × (1 + 0.10) = $110
In two years: $110 × (1 + 0.10) = $121
or $100 × (1 + 0.10)2
In three years: $121 × (1 + 0.10) = $133
or $100 × (1 + 0.10)3
In n years
$100 × (1 + i)n

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Simple Present Value (1 of 2)
PV = today’s (present) value
CF = future cash flow (payment)
i = the interest rate

CF
PV 
(1  i )n

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Simple Present Value (2 of 2)
• Cannot directly compare payments scheduled in different
points in the time line

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QUESTION 3 P.83

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Four Types of Credit Market Instruments
• Simple Loan
• Fixed Payment Loan
• Coupon Bond
• Discount Bond

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Yield to Maturity
• Yield to maturity: the interest rate that equates the present
value of cash flow payments received from a debt
instrument with its value today

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Yield to Maturity on a Simple Loan
P V = am ount borrow ed = $100
CF = cash flow in one year = $110
n = num ber of years = 1
$110
$100 =
(1 + i )1
(1 + i ) $100 = $110
$110
(1 + i ) =
$100
i = 0.10 = 10%
For sim ple loans, the sim ple interest rate equ als the
yield to m aturity

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QUESTION 7 P.83

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Fixed-Payment Loan
The same cash flow payment every period throughout the
life of the loan
LV = loan value
FP = fixed yearly payment
n = number of years until maturity

FP FP FP FP
LV = + + + . . . +
1 + i (1 + i )2 (1 + i )3 (1 + i )n

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QUESTION 8 P.83

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Coupon Bond (1 of 6)
Using the same strategy used for the fixed-payment loan:
P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date

C C C C F
P= + 2
+ 3
+. . . + +
1+ i (1+ i ) (1+ i ) (1+ i ) (1+ i )n
n

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Coupon Bond (2 of 6)
• A coupon bond is
identified by four
pieces of information:
1. Face value
2. Agencies that issue
this bond
3. Maturity date
4. The coupon rate

Source: https://en.wikipedia.org/wiki/United_States_Treasury_security

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Coupon Bond (3 of 6)
• When the coupon bond is priced at its face value, the yield
to maturity equals the coupon rate.

We can show the statement by using simple algebra:

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Coupon Bond (4 of 6)
• The price of a coupon bond and the yield to maturity are
negatively related.

• The yield to maturity is greater than the coupon rate when

the bond price is below its face value.

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QUESTION 5 P.83

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Coupon Bond (6 of 6)
• Consol or perpetuity: a bond with no maturity date that
does not repay principal but pays fixed coupon payments
forever

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Coupon Bond (6 of 6)

= price of the consol

= yearly interest payment
= yield to maturity of the consol
One can rewrite the equation as:

For coupon bonds, this equation gives the current yield, an

easy to calculate approximation to the yield to maturity

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Discount Bond
For any one year discount bond
F  P
i=
P
F = Face value of the discount bond
P = Current price of the discount bond

The yield to maturity equals the increase in price over the year
divided by the initial price.

As with a coupon bond, the yield to maturity is negatively related

to the current bond price.
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QUESTION 6 P.83

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The Distinction Between Interest Rates and
Returns (1 of 4)
• Rate of Return:
The payments to the owner plus the change in value
expressed as a fraction of the purchase price
C P  Pt
RET = + t 1
Pt Pt
RET = return from holding the bond from time t to time t + 1
Pt = price of bond at time t
Pt 1 = price of the bond at time t + 1
C = coupon payment
C
= current yield = ic
Pt
Pt 1  Pt
= rate of capital gain = g
Pt
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QUESTION 9 P.83

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The Distinction Between Interest Rates and
Returns (4 of 4)
Table 2 One-Year Returns on Different-Maturity 10%-Coupon-
Rate Bonds When Interest Rates Rise from 10% to 20%
(1) (2) (3) (4) (5) (6)
Years to Maturity Initial Initial Price Rate of Rate of Return
When Bond Is Current Price Next Capital Gain [col (2) + col (5)]
Purchased Yield (%) ($) Year* ($) (%) (%)
30 10 1,000 503 −49.7 −39.7
20 10 1,000 516 −48.4 −38.4
10 10 1,000 597 −40.3 −30.3
5 10 1,000 741 −25.9 −15.9
2 10 1,000 917 −8.3 +1.7
1 10 1,000 1,000 0.0 +10.0
*Calculated with a financial calculator, using Equation 3.

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 The Distinction Between Interest Rates and
Returns (2 of 4)
• The return equals the yield to maturity only if the holding period
equals the time to maturity.
• A rise in interest rates is associated with a fall in bond prices,
resulting in a capital loss if time to maturity is longer than the
holding period.

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 The Distinction Between Interest Rates and
Returns (2 of 4)
• The more distant a bond’s maturity, the greater the size of the
percentage price change associated with an interest-rate
change.
• Interest rates do not always have to be positive as evidenced
by recent experience in Japan and several European states.

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 The Distinction Between Interest Rates and
Returns (3 of 4)
• The more distant a bond’s maturity, the lower the rate of return
the occurs as a result of an increase in the interest rate.

• Even if a bond has a substantial initial interest rate, its return

can be negative if interest rates rise.

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 The Distinction Between Real and Nominal
Interest Rates
• Nominal interest rate makes no allowance for inflation.
• Real interest rate is adjusted for changes in price level so it
more accurately reflects the cost of borrowing.
– Ex ante real interest rate is adjusted for expected changes
in the price level
– Ex post real interest rate is adjusted for actual changes in
the price level

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Fisher Equation
i  ir   e
i = nominal interest rate
ir = real interest rate
 e = expected inflation rate
When the real interest rate is low,
there are greater incentives to borrow and fewer incentives to lend.
The real interest rate is a better indicator of the incentives to
borrow and lend.

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